Focusing On Free Cash Flow Improves Your Returns

by: My Road to Half a Million

Summary

Cash flow is much trickier to manipulate than net income.

Investing based on cash flow statement has produced historically good returns.

Investing based on net income has yielded below average results.

Current accounting principles make the income statement pretty much useless as creative accounting and balance sheet changes can have a major impact on the bottom line. A good example can be found with Hershey (NYSE:HSY), when its last fiscal year it decided to make a hefty goodwill impairment charge because of excess price paid from Shanghai Golden Monkey. In practice, this made Hershey's bottom line and ability to make profit look very unappealing, even though this did not have any material cash related effect. However, on the cash flow statement side, Hershey delivered solid figures as that section tracks only actual cash in- and outflows and not imaginary ones. At least for me, the income statement is mainly just an entertainment page providing little value apart from the top part information. Therefore, when I am tracking the financial success of my holdings, I heavily focus on the cash flows because that is what covers all dividend payments and share buybacks, not the net income.

I recall a long time ago reading studies stating the supremacy of investing based on cash flow instead of net income, so I wanted to verify if these statements were actually true in real life. Therefore, I simulated the difference between Low P/E and Low P/FCF based value strategies for which you can find the results below. Both of them were based on the following simple rules:

  • In the beginning of each April and October, rank all stocks based on their P/E and P/FCF ratios
  • Purchase 50 of the cheapest ones with equal weighting

Starting capital was $50k, simulation period was from 1988 to the mid-2014 for all US listed stocks during that time period. All dividends were reinvested and commission, taxes, spread, slippage, delistings and volume constraints were taken into account. The results were generated by PerShareData.

My findings were completely in line with previous studies, as a Low P/FCF portfolio vanquished without a doubt the Low P/E counterpart. The Low P/FCF delivered a solid 11.89% annual return after all fees and costs while S&P 500 delivered 8.25% and Low P/E a meager 5.03%. The FCF variant outperformed its index 55.74% of the time as compared to P/E's 43.78%. On a standard deviation basis, the FCF version was slightly more volatile but when comparing the best and worst 3 and 5 year returns, the FCF variant was a clear winner. In the 3 and 5 year period, the PE variant always lost to the FCF one and the outperformance was not tide to any specific timeframe but it was constant. Even when compared to S&P 500, the FCF version outperformed always when the timeframe was longer than 5 years which is a very good metric for any investment strategy. Even though the P/E strategy had fatter tails when it came to profits per trade, the FCF strategy had a return distribution curve centered more on the positive side than P/E had. All in all, Low P/FCF was superior when compared to Low P/E. You can check the portfolio performance for the 2 strategies below (the first picture describes the Low P/E performance while the second one is for Low P/FCF).

Low P/E portfolio value Click to enlarge

Low P/FCF portfolio value Click to enlarge

Still thinking of dismissing the importance of cash flow statement? Well, think again. At least my strategy relies heavily on cash cows and not on the income statement. The entire report for the P/E variant is accessible in here and P/FCF on the other hand through this link.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.